The original scheme of the IMF therefore, provided that:
- Each member-country would peg their own currency for exchanging with other currency of the globe, in terms of gold. In addition to the gold, most of the countries of the globe, have declared values of their currencies in terms of US dollar. The pegging of the currency value with gold and/or US Dollar is named as ‘par value’ of the currency.
- At the time of finalization of valuation of currency with gold, to make the easement the value of fine and pure gold per ounce was fixed at US dollar 35.
- The Cold and US Dollars were agreed upon as the official monetary reserves of member-countries.
- The market value of member country currency accepted within a margin of 1% of the par value. If the market value of currencies deviates to the extent of more than the permitted level, the country should take steps to devalue or up value the currency to correct the position.
- The member countries of IMF were allowed to devalue their currencies on their own. If the member country would like to devalue their currency more than 1 % then the approval of the IMF should be obtained. The IMF had no power to reject the proposal of member country, only they can advise the member country for course of action they feel correct.
- To come out from the temporary imbalance in the balance of payment situations, the IMF can grant short-term financial assistance to its member-countries. But if the problem of Balance of Payment is chronic, and seems to be permanent nature, then IMF suggest the member country to use permanent solutions like devaluation.
Working of the System:
For the smooth running of the system, the major industrialised countries other than the USA endeavoured to keep exchange rate changes to the minimum and maintain a common price level for tradable goods. As other countries were supposed to maintain the exchange rate, USA had to remain passive in foreign exchange markets.
On the other hand, USA had to follow a monetary policy that could provide a stable price level for tradable goods. Europe and Japan found it convenient to rely upon the USA to supply a stable price environment, and support US dollar as unit of account and means of settlement of international transactions.
The system provided a distinct advantage to the USA, viz., the seigniorage gains. A seigniorage gain means prerogative gains, by issuing coins and currency above their intrinsic value. It means that USA could obtain goods and services from abroad by merely printing US dollar, so long as the other countries were willing to accept dollar as the key currency.
The acceptance of dollar depended on the confidence the other countries had that their US dollar reserves could be used for settlement of their international debts or that they could convert their reserves into gold. This aspect proved to be both a strength and weakness of the system.
It was strength because dollar became a reserve asset in addition to gold providing additional base for creation of money supply to keep pace with increase in international trade. It was a weakness in the sense the system depended excessively on a single currency. This dependence ultimately brought the fall of the system.
Collapse of the System:
For about two decades the system worked smoothly. Slowly during the late sixties, the deficiencies of the system began to surface. One of the major difficulties was that the growth of means of settlement of international debts (international liquidity) did not keep pace with the increase in the volume of international trade.
Many countries began to experience balance of payments problems. The reason can be attributed to the fact that increase in international liquidity depended upon the availability of gold. The supply of gold did not increase because its official price was fixed at US dollar 35 per ounce. With inflation and increased cost of mining, many countries found it uneconomical to mine gold.
Bretton woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the United States, Canada, Western European countries, Australia, and Japan after the 1944 Bretton Woods Agreement. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent states. The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained its external exchange rates within 1 percent by tying its currency to gold and the ability of the International Monetary Fund (IMF) to bridge temporary imbalances of payments. Also, there was a need to address the lack of cooperation among other countries and to prevent competitive devaluation of the currencies as well.
Preparing to rebuild the international economic system while World War II was still being fought, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial Conference, also known as the Bretton Woods Conference. The delegates deliberated from the 1st to the 22nd of July, 1944, and signed the Bretton Woods agreement on its final day. Setting up a system of rules, institutions, and procedures to regulate the international monetary system, these accords established the IMF and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. The United States, which controlled two-thirds of the world’s gold, insisted that the Bretton Woods system rest on both gold and the US dollar. Soviet representatives attended the conference but later declined to ratify the final agreements, charging that the institutions they had created were “branches of Wall Street”. These organizations became operational in 1945 after a sufficient number of countries had ratified the agreement. According to Barry Eichengreen, the Bretton Woods system operated successfully due to three factors: “low international capital mobility, tight financial regulation, and the dominant economic and financial position of the United States and the dollar.”
Smithsonian Agreement:
The state of instability and confusion led the other countries to devote immediate attention to the issue. Ten major industrialised countries of the world (the USA, Canada, Britain, West Germany, France, Italy, Holland, Belgium, Sweden and Japan) which came to be known as the ‘Croup of Ten’ met at the Smithsonian building in Washington during December 1971 to solve the dollar crisis and to decide about the realignment of the currencies. The agreement entered into known as the ‘Smithsonian Agreement’, and came into effect from December 20, 1971.
The following actions where decided and taken:
- The US dollar was devalued by 7.87% and the new dollar-gold parity was fixed at US dollar 38 per ounce of gold.
- The other major countries decided to revalue their currencies. Japan revalued its currency in relation to dollar by 7.66% and West Germany by 4.61 %. This meant that in relation to gold, the Japanese yen was revalued by 16.88% and the Deutsche Mark by 12.6%.
- It was provided for a wider band of fluctuation in exchange rates. The exchange rates were allowed to fluctuate within 2.25% on either side instead of 1% existing previously. This step was taken with a view to affording greater flexibility to exchange rates in the market.
- The USA removed the 10% surcharge on its imports, but the non-convertibility of dollar into gold continued.
The USA faced unprecedented balance of payments deficit for the year 1971 characterised by increased imports due to domestic boom. Dollar continued to fall in the exchange market. A number of countries tried to save the situation by purchasing dollar in large quantities. The situation was beyond repair by these methods and hence the USA devalued dollar for the second time on February 13, 1973.
The extent of devaluation this time was 10% with the gold value increasing from US dollar 38 to US dollar 42.22 per ounce. Following the second devaluation of US dollar, many countries, including Japan, West Germany and UK, started floating their currencies. Thus, the Smithsonian Agreement came to an end.
Abolition of Gold and Emergence of Special Drawing Rights (SDR):
The turmoil in the exchange market continued. The dollar continued to fall and Japanese Yen and Deutsche Mark emerged strong. Major currencies of the world continued to float.
The Committee which had 20 principal members both from developed and developing countries made a number of far-reaching recommendations on reforming the IMF system. The major recommendations relate to the place of gold in the IMF system and the use of Special Drawing Rights (SDR).
SDR is an artificial international reserve created by IMF in 1970. The SDR, which is a basket of currency comprising major individual currencies, was allotted to the members of the IMF. The members of IMF could use it for transactions among themselves or with the IMF. In addition to gold and foreign exchange, countries could use the SDR to make international payments.
The official price of gold was abolished in November 1975f putting an end to the gold era. The countries were free to purchase or sell for monetary reserve gold at the prevailing market price. SDR emerged as the international currency. No agreement could, however, be reached on a new system of exchange rates. The USA advocated floating rates, while France was for fixed rates and return to par values.
Fixed exchange rates
The rules of Bretton Woods, set forth in the articles of agreement of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), provided for a system of fixed exchange rates. The rules further sought to encourage an open system by committing members to the convertibility of their respective currencies into other currencies and to free trade.
What emerged was the “pegged rate” currency regime. Members were required to establish a parity of their national currencies in terms of the reserve currency (a “peg”) and to maintain exchange rates within plus or minus 1% of parity (a “band”) by intervening in their foreign exchange markets (that is, buying or selling foreign money).
In theory, the reserve currency would be the bancor (a World Currency Unit that was never implemented), proposed by John Maynard Keynes; however, the United States objected and their request was granted, making the “reserve currency” the U.S. dollar. This meant that other countries would peg their currencies to the U.S. dollar, and—once convertibility was restored—would buy and sell U.S. dollars to keep market exchange rates within plus or minus 1% of parity. Thus, the U.S. dollar took over the role that gold had played under the gold standard in the international financial system.
Meanwhile, to bolster confidence in the dollar, the U.S. agreed separately to link the dollar to gold at the rate of $35 per ounce. At this rate, foreign governments and central banks could exchange dollars for gold. Bretton Woods established a system of payments based on the dollar, which defined all currencies in relation to the dollar, itself convertible into gold, and above all, “as good as gold” for trade. U.S. currency was now effectively the world currency, the standard to which every other currency was pegged. As the world’s key currency, most international transactions were denominated in U.S. dollars.
The U.S. dollar was the currency with the most purchasing power and it was the only currency that was backed by gold. Additionally, all European nations that had been involved in World War II were highly in debt and transferred large amounts of gold into the United States, a fact that contributed to the supremacy of the United States. Thus, the U.S. dollar was strongly appreciated in the rest of the world and therefore became the key currency of the Bretton Woods system.
Member countries could only change their par value by more than 10% with IMF approval, which was contingent on IMF determination that its balance of payments was in a “fundamental disequilibrium”. The formal definition of fundamental disequilibrium was never determined, leading to uncertainty of approvals and attempts to repeatedly devalue by less than 10% instead. Any country that changed without approval or after being denied approval was denied access to the IMF.
The Flexible Exchange Rate Regime
A floating (or flexible) exchange rate regime is one in which a country’s exchange rate fluctuates in a wider range and the country’s monetary authority makes no attempt to fix it against any base currency. A movement in the exchange is either an appreciation or depreciation.
Free float (Floating exchange rate)
A floating exchange rate is a regime where the currency price of a nation is set by the forex market based on supply and demand relative to other currencies. This is in contrast to a fixed exchange rate, in which the government entirely or predominantly determines the rate.
Under a free float, also known as clean float, a currency’s value is allowed to fluctuate in response to foreign-exchange market mechanisms without government intervention.
Managed float (or dirty float)
Under a managed float, also known as dirty float, a government may intervene in the market exchange rate in a variety of ways and degrees, in an attempt to make the exchange rate move in a direction conducive to the economic development of the country, especially during an extreme appreciation or depreciation.
A monetary authority may, for example, allow the exchange rate to float freely between an upper and lower bound, a price “ceiling” and “floor”.